Computers

Xerox Bets Big on Services

Given its reliance on hardware, Xerox (XRX) got squeezed by the recession as companies stretched equipment further and put off purchases of new printers and copiers. The company's bold expansion into services, through the $6.4 billion acquisition of Affiliated Computer Services (ACS) announced on Sept. 28, represents an attempt to capitalize on the global recovery.

Buying ACS will triple Xerox's services revenues, to $10 billion, and help it benefit from companies' desire to do more with fewer workers, even as business comes back. ACS, which handles paper-oriented tasks such as billing and claims processing for governments and private companies, also gives Xerox a bigger toehold in health-care and government services, two areas primed to benefit from federal economic stimulus spending.

Xerox Chief Executive Ursula Burns says the company needed to make a large services acquisition to accelerate its transformation from a product company into a service provider. "The way we were going was going to take 10 years," she said in an interview. "The path we were on wouldn't have given us scale fast enough."

Taking a Page from Big Blue Other technology firms are taking a page from IBM (IBM), betting on services as a way to bring in steady revenues at a time when customers are keeping computers and other equipment longer to save money. Xerox's cash-and-stock bid for ACS represented a 34% premium to ACS's closing stock price on Sept. 25. It came a week after Dell (DELL) said it's paying $3.9 billion for information technology services company Perot Systems (PER), offering a 68% premium. Hewlett-Packard (HPQ) bought tech services company EDS for $13.9 billion in 2008. "Everyone is looking at the IBM model and trying to emulate it," says Eric Gebaide, a managing director at investment bank Innovation Advisors.

Burns, who pulled the trigger on Xerox's biggest-ever acquisition after less than three months as CEO , will need to prove to investors that Xerox's latest push to diversify beyond hardware will succeed better than failed attempts a decade ago. Rick Thoman, CEO in 1999 and 2000, led an expansion into inkjet printing, Xerox-developed software, and document management services, with disastrous results.

Then, Anne Mulcahy, who was chief executive from 2001 until this summer, pulled the company back from the precipice of bankruptcy and restored profitability by concentrating on core areas, including color and commercial printing. "Their strategy has waxed and waned based on the stock price," says Peter Falvey, a managing director at investment bank Revolution Partners, a division of Morgan Keegan & Co., who advised Xerox on a services company acquisition in 2006. "They've tried to get into ancillary markets with mixed success."

Facing a Tough Environment Burns says past attempts by Xerox to expand beyond selling printers, copiers, and the supplies that feed them ran into trouble because of management missteps, not a misplaced strategy. "If we had a problem in the Thoman era, it was about implementation, not the goals," says Burns, who started at Xerox as an intern in 1980 and became vice-president for worldwide manufacturing in 1999.

The company made changes without having new, replacement procedures in place, she says. For instance, the company pared 38 customer billing centers down to three in a bid to lower costs and improve quality, but lost control of collecting money owed to it. "It's just my humble opinion that this was not good management," Burns says. "We had to recover from that."

To be sure, Xerox is still facing a tough environment. Sales this year are expected to decline 16%, to $14.8 billion, and profits in the quarter that ended June 30 dropped 35%, to $140 million. Last October, Xerox laid off 3,000 workers, or 5% of its staff. But Burns says several years of improved earnings and cash flow have left the company better able to make acquisitions.

ACS: Medicare Claims Processor Xerox was already expanding, albeit modestly, in services. It bought a company called Amici in 2006 for $174 million to enter the business of helping lawyers organize digital documents during legal discovery. The following year it bought Advectis, which helps banks and consumers electronically manage mortgage documents, for $32 million. With ACS, "they're trying to buy revenue, certainly," says Revolution Partners' Falvey. "But the overall thesis is [Xerox] really wants to transform into a services-based business."

ACS's sales increased 6%, to $6.5 billion, for its fiscal year ended June 30. It's one of the largest processors of Medicare claims, along with HP's EDS unit. "There's no doubt it's good news that they're critical to health-care IT. This is where the money is being spent," says Burns. ACS, which tried to sell itself two years ago to private equity firm Cerberus Capital Management before the deal fell through, had been anticipated by bankers again this year to be an acquisition candidate.

By selling more consulting and outsourcing services, hardware companies like Xerox and Dell hope to counteract declining hardware revenues. Corporate purchases of copiers and printers are expected to remain flat for the foreseeable future, and worldwide PC sales are expected to decline 2% in 2009, according to market researcher Gartner (IT). Meanwhile, sales of IT services grew 8.2% in 2008 to $806 billion. Services contracts can tie customers to vendors for longer periods of time than hardware sales can, says Dane Anderson, a Gartner analyst.

Behind E-ZPass, Too Investors are also starting to reward technology companies that diversify as a way to guard revenues during downturns, says banker Gebaide. "We've been in a world where specialty plays have been the pinnacle of how companies are analyzed," he says, referring to the tendency to focus narrowly on given markets or product lines. Now, companies that combine hardware, software, and services "will have a lot more places to be protected."

So far, Xerox's role in the so-called business process outsourcing market has been minimal. Of the company's $3.5 billion in annual services revenue, $3.2 billion came from maintaining and managing printers and other office machines, according to Burns. About $300 million has been from "more advanced" process outsourcing services akin to what ACS does.

Burns' bet is that Xerox can apply its globally recognized brand and worldwide sales presence to expand ACS into Britain, Germany, Spain, and other parts of the world. About 92% of the Dallas-based company's revenues come from the U.S. "The rest of the world doesn't even know who ACS is," she says. Xerox also plans to use its technology for computerized scanning and organization of documents to improve such ACS tasks as operating the E-ZPass automated toll system, or processing insurance paperwork.

Dealmaking Frenzy Xerox expects to save $300 million to $400 million in the first three years after the deal closes in the first quarter of 2010, and said the deal will add to profits in the first year after it's completed. On Sept. 28, shares of Xerox closed down 1.30, or 14.4%, at 7.68. ACS shares gained 6.61, or 14%, to close at 53.86.

Xerox's ACS buyout arrives amid a flurry of post-Labor Day dealmaking. In technology, Adobe Systems (ADBE), Intuit (INTU), and Google (GOOG) each announced acquisitions this month. In pharmaceuticals, Abbott Labs (ABT) said on Sept. 21 it would acquire the drug and vaccine business of Belgian chemical company Solvay for $6.6 billion.

Burns and her team at Xerox aren't known as dealmakers, and bankers point out that the company will likely have its hands full folding in ACS, which has 74,000 employees, compared with Xerox's 54,000. Burns argues that Xerox plans to run ACS as a standalone business, and can eliminate people from its processes. "It won't be tough at all because we have no intention of integrating it," she says.

Xerox, an icon of American business whose name is synonymous with photocopying, has been making a slow climb back from its nadir in 2001. If the company finally hopes to prove to investors that it's retooling for the Digital Age, it will need to diversify much more carefully than the last time it tried expanding beyond its bread-and-butter business.